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Wednesday, September 15, 2010

Valuing Gold

A couple of years ago, major media outlets would post daily articles reporting the price of oil and how demand is far exceeding supply. Not long before that, these same outlets were saying things like "they're not making any more land" as housing prices rose through the roof. A few years before that, the rising stock prices of technology companies were making daily headlines as the stock market had entered what was claimed to be a "new paradigm shift, where traditional methods of valuation no longer apply". Today, it's the price of gold that is the talk of the town.

Why does the topic of gold garner so much interest today from major media outlets and bloggers alike? Because so many readers are interested (thus generating traffic), and the readers are likely interested because they own gold themselves. Indeed, demand for this asset has risen to such an extent that the price of gold continues to rise to new all-time highs almost daily:

Does this represent an asset bubble? To answer that, we must try to determine the intrinsic value of gold. The intrinsic value of any investment is the sum of the discounted future cash flows the investment will generate. Unlike a bond or a stock, however, there is no future cash flow expected from a bar of gold. In effect, the only reason one would purchase it as an investment is because one believes someone else will be willing to pay even more for it in the future.

In his book Margin of Safety, super-investor Seth Klarman argues that this form of investing is not really investing at all, but rather speculating. As the price of any asset rises, speculators enter the market expecting to unload the asset on someone else at a future date at a higher price. While this process can go on for months and even years, with speculators accumulating small profits along the way, eventually a large group of buyers will be left holding the bag when the party is over, with massive losses.

There are, of course, industrial and commercial uses for gold. But has the supply/demand dynamic for this metal changed so much in the last few years so as to warrant the large price run-up? Not likely. Therefore, the price has been pushed up by speculators.

Gold bugs/speculators argue that gold acts as a safe haven when currencies lose value. As central banks around the world add liquidity to stimulate the world economy, currencies should be worth less, they argue. However, due to the fact that the velocity of money has slowed (i.e. money isn't changing hands as quickly as it did during the boom) and capacity utilization is low, inflation numbers are tame despite the large amounts of currency being generated. Therefore, gold is running up on the expectation that the Fed will not be able to control inflation later. Even if one is correct about this (and it is far from a foregone conclusion), how does one quantify what gold is worth under such a scenario? When one buys a security without knowing its underlying value, one is susceptible to large losses. Buying "because the price is going up" is not an acceptable reason to buy for the Intelligent Investor.

For value investors, it is wise to avoid falling prey to these psychological frenzies. Investors should stick to buying securities which trade at discounts to their intrinsic values, intrinsic values which can be conservatively estimated. As such, gold is currently not an area where the value investor should foray.

Well done, Raj. I am going to keep this article on hand. Every now and then I talk to a gold bug who can't really get past these simple points. They are really evangelical about their belief in this shiny metal, and that scares me.

As you know I'm a big fan, and enjoy your blog tremendously. That said, I think you may be framing the case for gold improperly here.

After all, there is a reason why Einhorn, Michael Burry, and so many other value investing legends have been, and continue to, buy gold in their portfolio's (and its not because they are foolishly following a greater fool theory).

So with that in mind, I would humbly recommend you give Passport Capital's masterfully done essay on the case for Gold a few serious read through's when you get the chance. At an absolute minimum I think it will provide you with a lot more insight into the case for Gold in general, as well as the underlying rationale/thinking behind so many of the worlds best investors. I have posted the link below...

As far as your Klarman quote, I think it is quite interesting that he too has seemingly changed his mind on the issue. As Paul has already pointed out, his most recent interview clarifies his position on gold in the current environment. Anyhow, looking forward to your thoughts when its easy.

like many of you, i have mixed feelings. I purchased it in 2004, like another poster, but i'm becoming a bit more concerned. when you see things like this, alarms start to go off. then again, it may go to $3000 an oz! who knows

History has shown us time and time again that an all time high is an indicator to go short an asset class. It may enjoy a little run, but inevitably goes back down again. It's only a matter of time until gold does the same thing.

Given our government's - and the rest of the developed world's for that matter - current (and unsustainable) monetary and fiscal policies, how are you comfortable with the value of the dollars that your using in your IV estimates? As Klarman alludes to, an investment in Gold at this point is essentially a macro hedge against the very real reality that the daily devaluation of fiat currencies will continue unabated for the forseable future (I would argue its actually a near certaintly). In other words, its all about the preservation of purchasing power and has absolutely nothing to do with being able to determine the IV of gold so to speak, and everything to do with the inability to confidently determine whether the dollars we earn on our investments 5+ years from now will be worth anything close to what they are today in real terms.

Again, this "race to the bottom" that the hugely indebted governments of the devoloped world are taking part in will almost certainly end in tears...with the "real" value of these fiat currencies significantly lower relative to gold in real terms. For example, Berkshire's 1979 letter to shareholders is illuminating in this regard...

"...our book value at the end of 196e would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earningslyalong with much blood, seeat and tears, the book valueproduced will buy about the same half ounce. A similar comparison could be drawn with middle eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil, We intend to continue to do as well as we can in managing the internal affairs of the business. But you should understand that external conditions effecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway."

That is what I was getting at when I said you may be "mis-framing" the issue.

2) I would say who cares what has happened in the rearview, as the pertinent question here is what will happen going forward. Just as its important not to extrapolate past trends indefinitely into the future, its equally as important not to expect things to change just becuase they are "due" for a reversion to the mean so to speak. As long as the governments of the developed world continue to print money and/or incur huge and growing debts Gold should continue to do incredibly well.

Again, at this point their current trajectory will lead to one of two outcomes, those being either outright default or competitive currency devaluation (earily, Japan's intervention regarding the Yen over the last couple of days is imho a preview of what's to come). Notably both outcomes are devestating for fiat currencies and wildly bullish for gold, so I guess that's a long winded way of saying why it makes sense today and for the forseable future to allocate a portion of your capital to gold. The bottom line is that until the governments of the developing world get their financial houses in order, the price of Gold should continue to rise (or at least remain stable). Unsurprisingly, a close examination of history suggests as much which is important to keep in mind here as well.

Given our government's - and the rest of the developed world's for that matter - current (and unsustainable) monetary and fiscal policies, how are you comfortable with the value of the dollars that your using in your IV estimates? As Klarman alludes to, an investment in Gold at this point is essentially a macro hedge against the very real reality that the daily devaluation of fiat currencies will continue unabated for the forseable future (I would argue its actually a near certaintly). In other words, its all about the preservation of purchasing power and has absolutely nothing to do with being able to determine the IV of gold so to speak, and everything to do with the inability to confidently determine whether the dollars we earn on our investments 5+ years from now will be worth anything close to what they are today in real terms.

Again, this "race to the bottom" that the hugely indebted governments of the devoloped world are taking part in will almost certainly end in tears...with the "real" value of these fiat currencies significantly lower relative to gold in real terms. For example, Berkshire's 1979 letter to shareholders is illuminating in this regard...

"...our book value at the end of 196e would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earningslyalong with much blood, seeat and tears, the book valueproduced will buy about the same half ounce. A similar comparison could be drawn with middle eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil, We intend to continue to do as well as we can in managing the internal affairs of the business. But you should understand that external conditions effecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway."

That is what I was getting at when I said you may be "mis-framing" the issue.

2) I would say who cares what has happened in the rearview, as the pertinent question here is what will happen going forward. Just as its important not to extrapolate past trends indefinitely into the future, its equally as important not to expect things to change just becuase they are "due" for a reversion to the mean so to speak. As long as the governments of the developed world continue to print money and/or incur huge and growing debts Gold should continue to do incredibly well.

Again, at this point their current trajectory will lead to one of two outcomes, those being either outright default or competitive currency devaluation (earily, Japan's intervention regarding the Yen over the last couple of days is imho a preview of what's to come). Notably both outcomes are devestating for fiat currencies and wildly bullish for gold, so I guess that's a long winded way of saying why I believe that it makes sense today and - for the forseable future - to continue to hold a portion of your capital in gold. I will likely continue to believe that until the governments of the developing world get their financial houses in order, as until then the price of Gold will continue to rise or at least remain stable (unsurprisingly, a close examination of history suggests as much and thats important to keep in mind as well...i.e., gold has always done well when governments have been on similarly irresponsible and unsustainable paths).

1) I do recognize that the current loose monetary and fiscal policies could increase inflation in the future. However, my hedge against that would be real estate, or some other commodity that we need, as businesses with inflated revenues and consumers with inflated salaries will have to pay inflated prices for real estate. Gold, on the other hand, has more psychological use than physical, so I have a hard time understanding the argument that it is an inflation hedge. Real estate prices remain subdued, however, despite these apparent inflation threats! How does one explain that?

2) I agree with you that the past prices have no bearing on what it's worth now. What I was trying to say is that if someone is going to make the argument that gold demand outstrips supply, the price at which to take advantage of that mismatch was last year or 10 years ago, not now when everybody else is piling in.

I have a major part of my assets in gold and my average entry price is about half of what it's worth now. It was never intended as a trade but as a permanent protection from inflation and uncertainty. It would keep me safe from whatever the US government might do. I was willing to forgo earnings/interest and willing to take on extra counterparty risk (compared to treasuries) to accomplish capital gains equal to the real inflation rate. Now I find myself in the midst of a bubble and cringe every time I see it rally because bubbles always burst and usually it happens before you can even blink. I don't use options either that might allow me to hedge. What do you think, should I be feeling good or bad about the position?